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Summary Financial Accounting Theory
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Summary Financial Accounting Theory
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Week 1: Introduction to financial accounting theoryAccounting scandals are financial disasters which destroyed companies and peoples’ lives; people
lost jobs, shareholders and lenders lost their money, government is not able to collect the taxes.
Many of the scandals are a result of the excessive greed of a few individuals misusing accounting
> Top 10 scandals: Enron, WorldCom, Waste Management, Tyco, HealthSouth, Freddie Mac,
American International Group, Lehman Brothers, Bernie Madoff, Satyam
Scandals can not be prevented by accounting, but the effects will not be so large as it was!
Accounting is of importance, because the miss-use of accounting can have large economic and
political consequences, like a change in the regulations (Sarbanes-Oxley Act). Using accounting in a
proper way means that we could prevent these things from happening!
Accounting in theory > science or skill
Skill; doing book-entries in the general ledger by following the rules and requirements, to
come up with a balance sheet, income statement, and cashflow statement; book of recipes
Science; theories behind accounting. We don’t have something as an (financial) accounting
theory! We use theories from other fields to explain why we see accounting as we see it
today, and the changes in the accounting environment. Understand and appreciate the role
of financial accounting in a market economy
Theory: a construction of logical reasonings to increase our understanding of accounting practices
and to help guiding future developments (with respect to the change in accounting) therein.
Accountants are controllers, people inside the company that manage the information stream!!
History: where accounting comes from, and describes how we came to the accounting of today. If
there is a crash, people start to think about how to prevent such a crash from happening again in the
future by changing the accounting regulations
Mainstream accounting research: Stock market crash in the U.S. (1929), the whole market
plummeted down. This resulted in political reactions through two securities (exchange) acts
(1933 & 1934) including a Securities Exchange Commission (SEC) to protect investors, and
people in general, from the misuse in the future, by letting the private sector (accountants/
auditors) creating rules, regulations, standards, and conceptual frameworks, and see that
people and companies in the markets at heard to these rules.
o An important problem in the framework was to define income, earnings, and profit,
because of the abstract concept. It’s a hard number, but an estimation
o The issue that it’s impossible to have a perfect both at the same time; balance sheet
orientation with a shareholder’s equity close to real economic value of the company
or income statement orientation with a good performance measure
Before the crash the focus was much more on the balance sheet, based on current value
accounting like discounted cash flow. But these numbers are difficult to audit, because of its
estimation factor. After the crash the focus become on the income statement, based on
historical values/costs match
1960s: change in the accounting research because people could not agree what income
could be. New theories from finance and general economic were used
o Rational decision making under uncertainty; how to make good decisions when you
are confronted with uncertainty about the future. What does the future cashflow
mean for the cash today
o Efficient securities markets: the functioning of capital market, like the Euronext. To
what extend do they resemble the real price and real economic value
, o Information economies: information has economic value too. There is an unequal
distribution of information about transaction parties; information asymmetry
In this time there was a shift in focus towards the decision usefulness of accounting
information, where they looked at the most important decision maker and their problems in
order to help them by providing useful accounting information by a conceptual framework
2000s: again a security market crash in the high-tech industry (internet bubble). Changes in
the accounting regulations were related to;
o Revenue recognition: issue when to include the revenues in the income statement
and recognize it as part of the earnings and economic performance. New, high-tech
companies in the IT-industry made a lot of costs and less revenues in the beginning.
In order to grow they needed investors, so they should present profits through
aggressively recognizing revenues
o Accounting for special financing arrangements; special purpose entities (SPE). Use of
subsidiaries, that don’t have to be consolidated, to present a lower debt than the
real economic debt on the balance sheet; misuse of information for investors
o Corporate governance regulation; Sarbanes-Oxley Act in the U.S. where the CEO and
CFO became personally liable for the information provided to investors, and the
governance commissions in Europe that introduced governance rules
2007/2008: financial crisis due to non-transparency and fraud in the asset backed securities
market by banks and financial institutions.
o Fair value accounting for financial instruments: as the alternative for historic cost
accounting. Fair value accounting can be based on market prices, but if the market
doesn’t function well anymore, due to a crash, numbers are lower than reasonable
o Accounting for special financing constructions; accounting for financial leverage, off-
balance sheet leverage
Nowadays we still see this type of regulation where the markets are regulated by laws (U.S) and
(government) commissions (Europe) who created good practices.
Accounting is not an exact science! Frameworks will change over time! People and their behaviour
are important in the accounting area, because they make choices, which we see in accounting
Primary theory that underlies and explains the concepts of the conceptual framework in information
economics, is about the three main developments during the 1960s, and the uneven distribution of
information across (transaction) parties with 2 (equal important) information asymmetry problems
Adverse selection problem: What are you willing to pay for a particular share? You need
information about the company in order to trust the company before you buy shares.
Normally the founder/executives of the company know more than people outside the
company, so they need to inform investors about the quality of the company. However, they
want to sell the shares so they are probably too positive about the company, which means
the interests of the seller and buyer are not aligned. Because of this there is the need for a
third party that increases the value/information content > accounting people
selling shares to investors with performance measures used as accounting
information to measure the value of the company (chapter 2-7)
Moral hazard problem: How much are you willing to pay the CEO? You can chose to pay a
fixed salary, but for economic reasoning its better to pay variable salary, to motive manager
to do well for the owners of the company. However, its hard to measure the real
performance of the executive due to external factors that increase the profit; you want to
reward based on the extent of their contribution. All good information is good for the
shareholders, but not everything is because of good performance (inform owner)
, hiring good people by using performance of (top) management or executives as
accounting information to give them incentives to perform more wealth for the firm and
assess their quality and price (chapter 8-11)
Fundamental financial accounting problem: the two problems based on information economics and
the fact that there is an uneven distribution of information (transactions) can be solved, but not at
the same time! If you focus on one issue only, you will get another conceptual framework and
standards than if you focus on both. There is no financial accounting theory that can tackle both!
Quality of accounting information include two trade-offs that can be made
Relevance vs. Reliability: relates to informing potential shareholders. They need information
that is relevant and reliable, however you need to make a trade-off between the 2 since you
cannot have fully reliable and fully relevant at the same time (adverse selection)
o Relevant information; related to the (future) value of the share/company
o Reliable information; to what extend can you trust/rely the controllers or CEO in the
company that report the information about (future) performance
Sensitivity vs. Precision: relates to information that measures the performance of the
managers. They can perform very well, but in the end the net income might be lower. In
order to see how well a manager performed, compared to other companies, you make the
distinction between (moral hazard)
o Sensitivity; relates to relevance. The information reacts quickly to a measure or
decision that has been inputted by managers
o Precision; relates to reliability. There is a slower react, but the reaction of the
managers’ decision is more precisely in terms of evaluation
Theory of perfect accounting (ideal conditions)
In ideal conditions there are no accounting problems in the economy! Under ideal conditions the
present value model (discounted cashflow model) provides the upmost (100%) in relevant and reliable
(financial) accounting information. Something what is impossible in reality!
Current value accounting: as a method you can use
o Discounted cashflow model; estimate the cashflow at the end of a period. You want to know
- The possible cashflows at the end of the period. There is uncertainty about which
cashflow is going to happen, but there is no discussion about these cashflows.
- The likelihood that you enter in a particular stage at the end of the period. If there
are only 2 stages and everyone agrees it about the likelihood to enter in a stage (as
long as it counts to one)
- There is time value of money involved, but there is no risk value involved; everyone
is risk neutral, which is included in the discount factor which is used to discount
future cashflows to the present
With this information you can calculate the present value that everyone agrees upon,
because under ideal conditions everyone agreed about the future possibilities, likelihoods,
cashflows, and discount rate. There is no uncertainty
o Market prices; under ideal conditions it should be the same
Relevant information; information about the future economic prospects and possible outcomes
(possible cashflows, states of nature, risk free interest rate, likelihoods)
Reliable information; information should be complete and everything that is necessary should be in
it, without (intangible) biases (earnings management). According to the conceptual framework of
IFRS and US GAAP there is a difference between reliable (betrouwbaar) and faithful (getrouw)
Reliable; with respect to future cashflows information can be verified by auditors
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